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Prati (ALM) PDF
Prati (ALM) PDF
An Overview
An Oracle White Paper
July 2005
Measuring Risk
The function of ALM is not just protection from risk. The safety achieved through
ALM also opens up opportunities for enhancing net worth. Interest rate risk (IRR)
largely poses a problem to a bank’s net interest income and hence profitability.
Changes in interest rates can significantly alter a bank’s net interest income (NII),
depending on the extent of mismatch between the asset and liability interest rate
reset times. Changes in interest rates also affect the market value of a bank’s equity.
Methods of managing IRR first require a bank to specify goals for either the book
value or the market value of NII. In the former case, the focus will be on the current
value of NII and in the latter, the focus will be on the market value of equity.
In either case, though, the bank has to measure the risk exposure and formulate
strategies to minimise or mitigate risk.
The immediate focus of ALM is interest-rate risk and return as measured by a bank’s
net interest margin.
Simulation analysis
Simulations serve to construct the risk-return profile of the banking portfolio.
Scenario analysis addresses the issue of uncertainty associated with the future
direction of interest rates by allowing the analysis of isolated attributes with the
use of ‘what if’ simulations. However, it is debatable if simulation analysis, with its
attendant controls and ratification methods, can effectively capture the dynamics of
yield curve evolution and interest rate sensitivity of key financial variables.
Conclusion
As the landscape of the financial services industry becomes increasingly competitive,
with rising costs of intermediation due to higher capital requirements and deposit
insurance, financial institutions face a loss of spread income. In order to enhance the
loss in profitability due to such developments, financial institutions may be forced
to deliberately mismatch asset/liability maturities in order to generate
higher spreads.
ALM is a systematic approach that attempts to provide a degree of protection to
the risk arising out of the asset/liability mismatch. ALM consists of a framework
to define, measure, monitor, modify and manage liquidity and interest rate risk. It
is not always possible for financial institutions to restructure the asset and liability
mix directly to manage asset/liability GAPs. Hence, off-balance sheet strategies
such as interest rate swaps, options, futures, caps, floors, forward rate agreements,
swaptions, and so on, can be used to create synthetic hedges to manage asset/
liability GAPs.
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